In the past, parties entered into over the counter (“OTC”) derivative transactions by negotiating separate agreements for each transaction. Each agreement would by necessity include the legal and financial relationships between the parties. Each time the parties entered into a transaction, all of the terms and relationships would have to be negotiated. To improve efficiency, parties often enter into a “master agreement” which provides the framework for ongoing legal and credit relationships that will govern all future transactions. Often, a master agreement will cover different types of transactions, e.g., currency swap, cross-currency swap, interest rate swap, commodity swap, basis swap, option, future, etc., avoiding the need for parties to enter separate agreements for each transaction type.
One such master agreement is offered by the International Swaps and Derivatives Association, Inc. (“ISDA”). When parties negotiate and execute an ISDA Master Agreement they agree to an ongoing legal and credit relationship. Typical ISDA Master Agreements include the 1992 and 2002 versions of the Master Agreement, both of which are incorporated herein by reference. ISDA also publishes supplementary materials related to various types of transactions, including definitions of terms typically used in the Master Agreement, schedules, and related confirmations. These definitions are typically incorporated into the Agreement.
A more detailed description of the ISDA Master Agreement and associated materials is provided at http://www.isda.org. An introduction to derivatives is also provided at http://www.isda.org/educat/pdf/ten-themes.pdf, and a further description of derivatives and the ISDA is provided at http://www.isda.org/educat/pdf/documentation_of_derivatives.pdf.
Parties who wish to amend the ISDA Master Agreement will typically negotiate schedules that amend, describe, and/or revise the Agreement, rather than amending the Agreement itself. Additional provisions not included in the Master Agreement may also be added via schedules. One provision that parties often revise or add is whether to be governed by New York or English law.
After two parties enter into a Master Agreement, only the terms of a subsequent transaction need to be negotiated and documented. The documents and any other confirming evidence exchanged between the parties which, taken together, confirm all of the terms of the transaction are defined as “confirmations.” Confirmations are normally subject to the terms of an associated Master Agreement, related schedules, definitions, etc.
Of particular interest are interest rate swap and cross-currency swap transactions. In a simple interest rate swap, one party pays a fixed interest rate on a principal amount (but wishes to pay a floating rate), and a second party pays a floating interest rate on a principal amount (but wishes to have a fixed rate payment). Accordingly, the parties may contract to “swap” payments, (i.e., to make payments to each other), which are in turn used to pay the interest due to their respective lenders. Contract terms of the swap typically include all relevant aspects of the transactions, including, e.g., the length of the contract, the number of payments per year, the number of total payments, the interest rates, the principal amounts involved, etc. In such a swap, each party makes two payments and receives one payment, with the received funds netting out one of the payments.
For example, suppose A and B have each taken out loans with the following terms: A pays a fixed 7% on principal to its lender in quarterly installments for 10 years and B pays a floating rate on principal to its lender in quarterly installments for 10 years. B's floating rate may be based on current interbank loan rates, i.e., the interest rate one bank borrows funds from another bank. However, the parties may agree to use any index or floating rate desired. Representative interbank loan rates include the London Interbank Offered Rate (“LIBOR”), or the Euro Interbank Offered Rate (“EURIBOR”).
As part of the interest rate swap, A and B may enter into an agreement where A pays B the floating rate amount and B pays A 7%. The effect of this agreement is that A initially contracted to pay a fixed rate (7%), and now pays a floating rate (RATE), i.e., receiving 7% from B and paying 7% to its bank, while also paying rate to B. The converse is also true, whereby B initially contracted to pay a floating rate (RATE) and now pays a fixed rate (7%), i.e., the netted effect of B receiving RATE from A and paying RATE to its bank, while also paying a fixed 7% to A.
There are many reasons why companies enter into such agreements, including leveraging relative or comparative market positions, hedging interest rate exposure, obtaining lower cost funding, or speculating how future interest rates will move. Despite different motivations or terms of these agreements, the effect is to “swap” a floating interest rate for a fixed one, and vice versa. Those skilled in the art will recognize that principal amounts for interest rate swaps are typically notional and not exchanged, and that the amounts due to the parties may be netted rather than having both parties make full payments to each other.
A cross-currency swap is similar to an interest rate swap, but with each part of the transaction denominated in a different currency. For example, suppose A wishes to have a principal amount in English pounds (£) and also wishes to pay a floating interest rate for 10 years. However, A's credit rating in the U.S. elicits more favorable loan terms when borrowing U.S. dollars ($) at a fixed interest rate. A may be able to borrow at 10% fixed and LIBOR+1.5% in the U.S., while only qualifying for a best U.K. fixed loan rate of 12% and a best floating loan rate of LIBOR+3%.
Accordingly, A may then borrow a principal amount in $ at a fixed 10% interest rate. A is then obligated to make interest rate payments to its original lender in $. A may then “swap” the U.S. principal for £, and negotiate a floating interest rate as well. To do this, A enters a cross-currency swap agreement with an exchange dealer, B, that will convert the U.S. principal into £, and also swap the 10% fixed interest rate (in $) for a LIBOR based interest rate (in £), e.g., LIBOR+2.25%. In this way, A has achieved its goal of borrowing £ and paying a floating interest rate while leveraging its favorable credit position in the U.S. As will be recognized, the fixed 10% payment (in $) due on A's principal loan amount is effectively paid by B (B pays a $ interest amount to A as part of the swap agreement), and A pays a floating LIBOR rate to B that is lower than the rate it could have achieved in the U.K. market itself (A pays a £ interest amount to B as part of the swap agreement).
As will be recognized by those skilled in the art, many variations on the above cross-currency swap exist, e.g., swapping one currency for another and a fixed for fixed interest rate swap, swapping one currency for another and a floating for floating interest rate swap, etc. Further, there are many scenarios where parties may enter into cross-currency swaps, e.g., investing in a foreign asset while eliminating foreign currency exposure, obtaining needed funds in one currency at the most favorable rates, creating synthetic foreign currency liabilities (debt) to offset foreign assets, etc.
As will be further recognized, where two parties contract to make payments to each other, there is a possibility that one of the parties may default on their payments. When one party defaults, the counter-party is still responsible for any payments due to their original lender. Accordingly, parties to interest rate or cross currency swaps may desire to limit their financial exposure in the event that their counter-party stops making payments. A party may stop making payments for any number of reasons, including bankruptcy, financial restructuring, other liquidation proceedings, or any other “termination event.” Termination events are typically described in the Master Agreement, schedules, or confirmations associated with a particular transaction and are types of events that will automatically terminate the remainder of the swap agreement.
Many approaches have been developed to reduce liability in the event of a termination event or other default, including a float asset approach and a flawed asset approach. These methods are known to those skilled in derivatives trading. The flawed asset approach is often called a “conditional payment” approach since a condition precedent to payment must occur. For example, a condition precedent to party A making a payment to party B may be that party B is not currently in bankruptcy. If B is in bankruptcy, A will make no payment until B fulfills the condition precedent to payment, i.e., comes out of bankruptcy. The 1992 ISDA Master Agreement contains such a provision in section 2(a)(iii), providing that a party is not obligated to make a payment where an Event of Default has occurred and is continuing. Events that are covered by the term Event of Default are defined within the Master Agreement, and include bankruptcy, merger without assumption, misrepresentation, etc. Where a Default event occurs, the non-defaulting party is under no obligation to make further payments under the agreement.
In the UK, for example, the flawed asset approach is used for interest rate swaps and results in a “self extinguishing” swap when a default (bankruptcy or other termination event) occurs. In particular, when a default event occurs, the swap self-extinguishes and its value goes to zero. This is beneficial in that it reduces the risk to the parties in the event of a bankruptcy or other termination event. For example, where a 10 year swap is executed, a default probability can be calculated using default probability curves or any known valuation method, and the potential value of the entire swap agreement at the time of a default can be determined and paid up front. Then, if a default occurred, the swap value would go to zero (extinguish), and no party would have further potential liability.
The flawed asset approach also has been used in Australia. In one instance, two parties entered into a Master Agreement and numerous swap agreements. Under their Master Agreement, when one party defaulted under the Event of Default provision, the other party had the option of terminating the agreement (and all related transactions) early, or withholding further transaction payments under a condition precedent clause similar to that described above. The non-defaulting party elected to withhold payments instead of terminating the agreement. The Australian courts ruled that the contractual condition precedent clause was valid, and the non-defaulting party was not obligated to make further payments.
As will be recognized by those skilled in the art, in the United States, non-debtors ordinarily cannot terminate contracts with debtors by relying on termination provisions that are triggered by the financial condition of the debtor or by the debtor initiating bankruptcy proceedings.
Termination of contracts between debtors and non-debtors is addressed in the U.S. Bankruptcy Code. In general, the Code prohibits terminating most types of contracts. These limitations are discussed in general at 11 U.S.C. §365(e)(1) [U.S. Bankruptcy Code §365(e)(1)]. However, certain types of agreements are granted safe harbor, and where properly drafted, provide additional safeguards to the non-debtor. In particular, certain swap agreements may benefit non-debtors in certain situations.
Section 101(53B) of the Bankruptcy Code defines a swap agreement as follows:                (A) an agreement (including terms and conditions incorporated by reference therein) which is a rate swap agreement, basis swap, forward rate agreement, commodity swap, interest rate option, forward foreign exchange agreement, sport foreign exchange agreement, rate cap agreement, rate floor agreement, rate collar agreement, currency swap agreement, cross-currency rate swap agreement, currency option, any other similar agreement1 (including any option to enter into any of the foregoing); 1“Any other similar agreement” is “best interpreted as including other agreements that from time to time are utilized by the swap market.” Collier on Bankruptcy, 15th ed. Rev., ¶101.53B.        (B) any combination of the foregoing; or        
(C) a master agreement for any of the foregoing together with all the supplements.
11 U.S.C. §101(53B) (emphasis added).
Agreements that qualify as swap agreements under section 101(53B) are entitled to the protections of, among other provisions,2 sections 362(b)(17) (the automatic stay does not apply to setoffs involving swap agreements)3 and 560. Section 560, captioned “Contractual right to terminate a swap agreement,” states: 2Pursuant to section 546(g), swap agreements are also exempt from a trustee's avoidance powers under section 544, 545, 547, 548(a)(1)(B) and 548(b) of the Bankruptcy Code.3Section 362(b)(17) states that the filing of a petition “does not operate as a stay of the setoff by a swap participant, of any mutual debt and claim under or in connection with any swap agreement that constitutes the setoff of a claim against the debtor for any payment due from the debtor under or in connection with any swap agreement against any payment due to the debtor form the swap participant under or in connection with any swap agreement or against cash, securities, or other property of the debtor held by or due from such swap participant to guarantee, secure or settle any swap agreement.”                The exercise of any contractual right of any swap participant to cause the termination of a swap agreement because of a condition of the kind specified in section 365(e)(1)4 of this title or to offset or net out any termination values or payment amounts arising under or in connection with any swap agreement shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title. As used in this section, the term ‘contractual right’ includes a right, whether or not evidenced in writing, arising under common law, under law merchant, or by reason of normal business practice. 4 The conditions specified in section 365(e)(1) include the insolvency or financial condition of the counterparty or its commencement of a case under Chapter 11.        
Further, the legislative history regarding swaps indicates the intent of Congress to provide additional protections to certain transactions.
Legislative History
Sections 101(53B) and 560 were added to the Bankruptcy Code in 1990. The relevant legislative history indicates that the purpose of the new sections was “to clarify U.S. bankruptcy law with respect to the treatment of swap agreements [and] . . . provide certainty for swap transactions in the case of a default in bankruptcy,” because interest rate and currency swap agreements are a “vital risk management tool in world financial markets.” Senate Report, 285, 101st Cong. House Banking Chairman Jim Leach noted that the “legal uncertainty surrounding swaps ‘threatens the safety and soundness of banks and poses systemic risk to the financial system as a whole.’” American Banker, Volume CLXV No. 144, quoting Rep. Leach. Congress was concerned that “if one of the parties to a swap agreement file[d] for bankruptcy under the current Bankruptcy Code, the non-defaulting party [will be] left with a substantial risk . . . [which] could cause a rippling effect which would undermine the stability of the financial markets.” Senator Heflin, Interest Swap: Hearing on S. 396 Before the Subcomm. on Courts and Administrative Practices of the Senate Comm. on the Judiciary, 101st Cong. 1 (1989). Furthermore, Representative Fish made clear that the swap sections were added to ensure the “stability of the swap market.” Collier on Bankruptcy, 15th ed., ¶ 560.LH at 560-11-12, quoting 136 Cong. Rec. H 2282 (May 15, 1990). Based on this legislative history, as well as the actual language of the code, it is clear that Congress intended to protect a broad variety of swap agreements in order to bring certainty to the swap market.
As will be recognized, enforcing swap agreements typically will be addressed in state courts. Since the ISDA Master Agreement provides a mechanism for parties to elect English Law or the law of the State of New York, a discussion of New York law is presented below.
New York State Law
Under New York law, where a liquidated damages provision bears a “reasonable proportion to the actual loss,” it will most likely be enforced. Equitable Lumber Corp. v. IPA Land Development Corp., 381 N.Y.S. 2d 459, 463 (NY 1976). In particular, where a liquidated damages provision in a swap agreement “call[s] for a value which represents the actual cost of cover for the Swap Agreement on the date of the default,” such provision will be honored. Drexel Burnham Lambert Products Corp. v. MCorp, 1991 Del. Super. Lexis 298, at *9 (Del. Superior Ct. 1991) (provision set damages as the costs to enter into a substitute agreement). Furthermore, in considering a liquidated damages provision, New York courts will consider the intent of the parties as set forth in such provision. See Truck Rent-A-Center, Inc. v. Puritan Farms 2nd, Inc., 41 N.Y.2d 420 (N.Y. 1977) (in honoring the liquidated damages provision, the court considered the fact that the provision stated that it was entered into by the parties based on the consideration of various factors, including the costs of the non-terminating party).
In some instances, parties may enter swap agreements that may be extended beyond their initial maturity date. For example, some prior art teaches an extendable interest rate swap (often called extendable or extendible swaps. See, for example, http://www.equanto.com/glossary/e.html and http://www.analyticalq.com/energy/volatility/table1.htm). However, these prior art extendable swaps are actually just interest rate swaps with an option to extend the swap at the same terms for an additional period or periods. Further, the pricing of the prior art extendable swaps does not contemplate numerous factors in the pricing of the swap, e.g., pre-settlement risk, defaulting parties, the periodic valuation of the swap, the periodic discounting of the swap, the probabilities of default of either party, the reduction in maximum liability, etc.
Additionally, less favorable pricing may be offered to the party that wishes to purchase the extension in exchange for the right to lock in an additional period under the current swap terms; i.e., the purchaser of the option to extend pays a premium for that option. For example, where on-market terms would require a party to make payments for a swap at a fixed 5.00%, the purchaser of the swap and option to extend may be required to make above market payments, e.g., 5.25%. Conversely, where on-market terms would entitle a party to receive a fixed 5.00% payment, purchasing the right to extend may result in unfavorable payments, e.g., 4.85%.
These prior art extendable swaps are unilateral extensions where one party elects to preserve the current terms of a swap agreement for additional time; i.e., such swaps give one party the right, but not the obligation, to extend the swap at some point in the future, usually at the original maturity date. The swap could be extended once, or more, for pre-defined periods (e.g. 2 additional years). Increasing the number of possible extensions typically results in an increased price for the party purchasing the option. However, the non-purchasing party could not initiate an extension, and the extension may not be automatic.
For example, a company may currently be making floating interest rate payments but may wish to make fixed interest rate payments. Accordingly they may enter a 2 year interest rate swap with a counterparty where they pay the counterparty a fixed market rate (e.g., a fixed 5.00%) and receive the floating payment amount. However, they may still be concerned that floating rates will be unfavorable at maturity, and may “purchase” an option to extend the current swap at the same terms for an additional 2 years. The pricing for this swap and option to extend may result in the company paying a higher fixed rate of 5.25% to the counterparty for the first 2 years with an option to extend at the same 5.25% for a second 2 year term (alternately, as described above, they may receive an unfavorable floating payment). While the company pays higher than market interest rate payments for the first 2 years (by 25 basis points), they have the security that should the floating rate rise above 5.25%, they can extend the swap for an additional 2 years at 5.25% rate. Of course, if the floating interest rates decrease, they can elect not to extend the swap. As will be recognized, the counterparty may wish to purchase the option to extend, and accordingly may receive unfavorable fixed payments (or may pay above market floating rates) for the option to extend.
As a second example, a company may issue a bond paying a fixed 5.00% coupon for 5 years, callable in 3 years. The company may wish to swap the fixed payments for floating payments based on LIBOR, but may also be concerned that the bond will be called in 3 years. Accordingly, they may enter a 3 year swap with a 2 year extension. The terms of an on-market interest rate swap may be the company paying LIBOR+some basis to the counterparty and receiving a fixed 5.00% payment. However, the extendable option may result in the company either paying LIBOR plus a higher basis, or receiving a lower fixed payment. If the bond is not called in the 3rd year, the company may elect to extend the current swap for the remainder of the bond's lifetime. If the bond is called, the company would most likely let the option expire worthless.
Additionally, as recognized by those skilled in the art, a transaction's value and any discounts based on event probabilities (e.g., probability of a default) are based on the lifetime of a transaction, and may not contemplate a periodic valuation of the transaction or periodic discounting probabilities. That is, any reduction in the value (i.e., discounting) may be applied to the calculated lifetime value of the transaction. These types of transactions may not consider the value of a sub-period of the transaction, and did not discount based on a probability calculated relative to a sub-period.
Therefore, it is apparent that there is a need for parties entering various financial transactions to be able to limit their exposure regarding an Event of Default (as defined in the ISDA Master Agreement, the associated schedules, and/or confirmations, such as bankruptcy, restructuring, etc.) Further, there is a need for a financial transaction that will extinguish at the end of a period in the event where particular conditions are not met during that period. There is also a need for a swap transaction that can be extended automatically at the end of a period that offers favorable pricing to the parties. Additionally, there is a need for a swap transaction that is valued using periodic calculations of values and that also utilizes periodic discount probabilities.